Berkeley Business Law Journal Volume 6|Issue 2 Article 2 June 2009 Supplying the Adverb: The Future of Corporate Risk-Taking and the Business Judgment Rule David Rosenberg Follow this and additional works at:https://scholarship.law.berkeley.edu/bblj Recommended Citation David Rosenberg,Supplying the Adverb: The Future of Corporate Risk-Taking and the Business Judgment Rule, 6 BerkeleyBus. L.J. 216 (2009). Link to publisher version (DOI) https://doi.org/10.15779/Z38CC52 This Article is brought to you for free and open access by the Law Journals and Related Materials at Berkeley Law Scholarship Repository. It has been accepted for inclusion in Berkeley Business Law Journal by an authorized administrator of Berkeley Law Scholarship Repository. For more information, please [email protected]. Supplying the Adverb: The Future of Corporate Risk-Taking and the Business Judgment Rule David Rosenberg' Introduction ............................................................................................. 2 17 The Prim acy of Risk-Taking ................................................................... 221 The Legal Framework for Evaluating Corporate Risk-Taking ................ 225 Stone v. Ritter, Good Faith, and the Business Judgment Rule ................ 229 Where Risk-Taking and Oversight Meet ................................................. 233 A G lim pse of the Future .......................................................................... 236 C onclusion ............................................................................................... 238 1. Associate Professor of Law, Law Department, Zicklin School of Business, Baruch College, City University of New York, and Associate Director, Robert Zicklin Center for Corporate Integrity, Baruch College. Contact: 646-312-3582; [email protected]. The author would like to thank Barry Adler, Andrew Gold, Larry Ribstein, Jonathan Rosenberg, Nathan Rosenberg and Bernard Sharfman for their helpful comments. All errors and shortcomings are mine alone. Supplying the Adverb Supplying the Adverb': The Future of Corporate Risk-Taking and the Business Judgment Rule I. INTRODUCTION Risk-taking is an essential aspect of virtually any business venture. The success of most enterprises depends on the ability of their leaders to evaluate risks and to decide which, of many courses, to pursue based on the likelihood and the magnitude of gain that each risk promises. The shareholders in corporations-like investors in any commercial entity-tolerate risk-taking because they understand that competitiveness, innovation, and profitability require decision-makers to pursue paths that have uncertain outcomes. Recognizing this, American law has consistently prohibited courts from holding corporate leaders personally liable for the consequences of risky decisions that do not succeed. Indeed, a hallmark of our commercial law has been the refusal of courts to second-guess the business judgment of corporate directors. This long-held policy of judicial abstention was sorely tested by the events of 2008. While a variety of causes undoubtedly contributed to the fall of so many financial institutions-and the loss of billions to shareholders-the most prominent among them was the mishandling of risk or, as one commentator succinctly called it, "really bad bets on mortgage securities."3 The unprecedented events of 2008 inevitably force us to examine how the law addresses risk-taking by corporate leaders and to re-evaluate when the law should hold those leaders liable for the consequences of their bad decision- making. The business judgment rule prevents courts from reviewing the decisions of corporate directors as long as the directors "acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."4 This means that aggrieved shareholders cannot hold directors legally5 responsible for even their most disastrous decisions unless the complaint clears a very high threshold. In justifying the broad protections provided by the business judgment rule, commentators and jurists highlight the 2. See Gagliardi v. Trifood Int'l, 683 A.2d 1049, 1052 (Del. Ch. 1996). 3. Saul Hansell, NYTimes.com, Bits Blog, How Wall Street Lied to Its Computers, Sept. 18, 2008, http://bits.blogs.nytimes.com/2008/09/18/how-wall-streets-quants-lied-to-their-computers. 4. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). 5. The corporate marketplace of course provides other means (of various levels of effectiveness) of sanctioning ineffective directors. Berkeley Business Law Journal Vol. 6.2, 2009 policy objective of encouraging risk-taking by corporate decision-makers.6 They argue that in order for a corporation to succeed in a highly competitive marketplace, it must test new ideas, pursue new markets, and create new products. Since many such inspired actions end in failure, the business judgment rule is necessary to protect directors from liability for such failures. According to conventional wisdom, the business judgment rule allows directors to take risks freely without fearing personal liability for the potential losses resulting from those risky actions. Supporters of a strict interpretation of the rule also point out the dangers of "hindsight review" in this context. When faced with claims that corporate directors acted improperly in making a decision which later turned out to be unfavorable, courts might second-guess the reasonableness of the directors' decision simply because something went wrong and thereby hold them legally responsible for the consequences. According to the oft-cited Delaware Court of Chancery, allowing such hindsight review would destroy "the entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation . . . with disastrous results for shareholders and society alike."7 Virtually every legal decision addressing the business judgment rule emphasizes the protection of corporate risk-taking as the best justification for the rule's broad scope. However, those decisions themselves rarely address allegations of excessive risk-taking or foolhardy speculation. Rather, most business judgment rule cases concern either the disloyalty of corporate directors (actions which clearly violate the duty of good faith) or gross negligence based on less-than-fully informed decisions or improper oversight. As the courts currently apply the rule, directors can escape liability even where there is little evidence that they exercised any business judgment at all. In justifying this kind of deference, courts claim that imposing liability in such cases would inhibit faithful directors from ever taking risks on behalf of the corporations that they oversee and lead.8 Judges essentially acknowledge that even if the directors consciously neglected their duties, the courts will not impose liability because it may inhibit other more faithful directors from taking risks that ultimately will benefit the shareholders.9 This attitude is perhaps illustrated best in an opinion by Delaware Chancellor Allen in Gagliardi v. Trifood International in which he disapproves of the possibility of holding directors liable for losses arising from a risky project where "the investment was too risky (foolishly risky! stupidly 6. See infra notes 22-40 and accompanying text. 7. In re Walt Disney Co. Derivative Litig. (hereafter "Disney IV "), 907 A.2d 693, 698 (Del. Ch. 2005). I quote the phrase "disastrous results" with no intended irony or reference to the events of 2008. 8. Gagliardi v. Trifood Int'l, 683 A.2d 1049, 1052 (Del. Ch. 1996). 9. See, e.g., id. Supplying the Adverb risky! egregiously risky! - you supply the adverb)."' 0 To allow liability for such decisions, he says, "would be very destructive of shareholder welfare in the long-term."'' Reluctant to supply an adverb that would result in liability, Allen says that all the business judgment rule requires from directors is good faith and adherence to "minimalist proceduralist standards of attention."'2 As this Article will argue, surely, the obligation of good faith requires that directors not make decisions that they know are "too risky" (in that the potential payoff is not justified by the likelihood of failure) 13 or where they know that they are ill-informed about the nature of the risks that they are authorizing. The corporate law of Delaware14 and of most states requires plaintiffs alleging breach of directors' fiduciary duty to claim not only that the directors made a bad decision but also that they made that decision in "bad faith.' 5 In addition to allowing recovery when directors act disloyally, this standard also allows shareholders to recover when they can show that the directors knew that they were making an uninformed decision, or an unreasonable decision, or an irrational decision-a high, but not unreachable threshold. Adverse decisions against directors arising, for instance, from failure to get the best price in a merger or acquisition 16 might be based on directors knowingly shirking their duty to obtain the information necessary to make that decision. For the most part, however, courts seem unwilling to impose liability in such cases but not because they cannot establish conscious disregard of the directors' duty in each particular case. Rather, courts fear that by imposing liability they will stifle the atmosphere of risk-taking that promotes innovation and increases shareholder wealth. Interestingly, this occurs even if the case in question has little to do with that particular type of risk and even if the defendants fail to present much evidence of good-faith adherence to duty by the directors. I propose that this apparent obsession with promoting and protecting risk- taking by corporate directors has lead Delaware courts to resist applying their own standard of good faith to cases in which plaintiffs might accuse directors 10. Id. I Id. at 1053. 12. Id. at 1052. 13. Allen is plainly using the term "too risky" in this sense. Neither Allen nor this Article is suggesting that directors might be held liable for decisions in which the likelihood of success is low but the payoffs disproportionately handsome. It is not a question of how much risk is tolerable; it is a question of whether the contemplated reward justifies the degree of risk. 14. This Article focuses on the law of Delaware because of its centrality as a source of American corporate law. 15. Stone v. Ritter, 911 A.2d 362 (Del. 2006). Until recently, the jurisprudence regarding the definition of bad faith was quite muddled. After years of inconsistent pronouncements, the Supreme Court of Delaware finally resolved most inconsistencies in the law in its decision in Stone. See also supra notes 64-77 and accompanying text. 16. See, e.g., Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). Berkeley Business Law Journal Vol. 6.2, 2009 of taking risks in violation of that duty. Further, courts could impose liability in such cases without threatening the beneficial aspects of the culture of innovation. Just as courts do not hold directors liable because they made informed-but-bad decisions, neither should they protect directors simply because they took risks. Shareholders should be allowed to recover where it can be shown that directors took a risk knowing that they were not adequately informed about the nature of the risk or knowing that the gravity of the risk plainly outweighed the potential gains. Ultimately, the decision to take a bold risk is not different from any other type of decision except that the chances that it will succeed are lower and, presumably, that the potential gain is greater. Courts are qualified to balance the unlikelihood of success with the potential benefits that would flow to the corporation in the event that the decision does succeed.'7 Further, courts should be more willing to examine the background of a risky action and conclude that the decision-makers knew that they were not adequately informed about the risks to justify a particular course of action. The widely accepted notion that the business judgment rule should protect virtually all risk-taking by corporate directors goes too far. Under Delaware law, a director should be liable for risky decisions that go wrong if the plaintiffs can show that the director knew that the decision was, to use Chancellor Allen's phrase, "too risky"' 8 or if the director did not even care to find out what the risks were. The burden that the law places on the plaintiff is to supply the adverb that brings the director's failing beyond the threshold of bad faith. Focusing on the current law in Delaware-in light of the 2006 Delaware Supreme Court decision in Stone v. Ritter19 that refined the definition of "good faith,"-I propose that courts are perfectly well-equipped to hear cases in which aggrieved shareholders claim that directors took improper risks in ways that ought to result in liability.2° I attempt to show that such review--even if the courts have, for the most part, refused to engage in it-would neither fall outside the prevailing boundaries of the business judgment rule nor damage the ability of corporations to take the kind of bold risks that have resulted in years of innovation and growth in the American corporate sector. Further, and perhaps most vitally, if the doctrine of good faith is to have any teeth at all, it must address all areas of director decision-making, including risk-taking. It is well within the ability of courts to decide whether or not a board intentionally made a risky decision, as Stone puts it, "with a purpose 17. See Franklin A. Gevurtz, The Business Judgment Rule: Meaningless Verbiage or Misguided Notion, 67 S. CAL. L. REV. 287, 305 (1994); D. A. Jeremy Telman, The Business Judgment Rule, Disclosure, and Executive Compensation, 81 TUL. L. REV. 829, 841-42 (2007). 18. Gagliardi v. Trifood Int'l, 683 A.2d 1049, 1052 (Del. Ch. 1996). 19. 911 A.2d 362 (Del. 2006). 20. This article does not address whether the directors' D & 0 insurance covers or ought to cover such misconduct. Supplying the Adverb other than that of advancing the best interests of the corporation. Although Stone and its most important predecessor, Caremark, involved the oversight function of the board, the good faith obligation imposed by those decisions should apply equally to directors' states of mind when they approve or make affirmative decisions to take actions, including risky ones. By seeming to exclude review of decisions to take risks, the Delaware courts currently disregard their own definition of the duty of good faith and limit the scope of the fiduciary duties of corporate directors to nothing more than the obligation not to self-deal. If consistency and clarity are to remain a hallmark of Delaware corporate law, the business judgment rule and the duty of good faith should apply to risky decisions in the same way that they apply to other actions and inactions taken by corporate directors. II. THE PRIMACY OF RISK-TAKING Arguments in favor of the risk-taking justification for the business judgment rule rely on four key notions: the role of risk-taking in wealth creation, the ability of shareholders to diversify their portfolios, the dangers of hindsight review, and the disproportionality of directors' potential payoff and potential liability. Taken together, these do indeed make a compelling case for the proposition that courts should not review the decisions of America's business leaders except in extraordinary circumstances. Not surprisingly, the great body of cases applying the business judgment rule and scholarship commenting on the nuances of the rule emphasize the importance of these elements in justifying application of the rule's protections even where corporate directors did not engage in "best practices."22 First, students of American law and economic history agree that much of our nation's technological progress and resulting economic growth arose not just through the inspired tinkering of a few great inventors but through the bold risk-taking of our great corporate innovators.23 When a corporation embarks on a risky venture, its leaders will likely justify the action on the grounds that, although the likelihood of failure is high, the venture will greatly benefit the corporation and its shareholders if it is successful. Often such risky projects 21. Stone, 911 A.2d at 369. 22. See, e.g., Disney IV, 907 A.2d at 697 ("This Court strongly encourages directors and officers to employ best practices, as those practices are understood at the time a corporate decision is taken. But Delaware law does not-indeed, the common law cannot- hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices."). It is important to note that advocates of near absolute business judgment rule protection for risk-taking acknowledge the distinction between the standard the law imposes and the standard of conduct that most of us would expect from reasonable and prudent directors. See, e.g., William T. Allen, Jack B. Jacobs & Leo Strine, Jr., Realigning the Standard of Review of Director Due Care With DelawareP ublic Policy: A Critique of Van Gorkom and its Progeny as a Standard of Review Problem, 96 Nw. U. L. REV. 449, 450 (2002). 23. For a discussion of the role of big firms in innovation, see WILLIAM J. BAUMOL, THE FREE- MARKET INNOVATION MACHINE 55-72 (2002). Berkeley Business Law Journal Vol. 6.2, 2009 fail, but there is little dispute that by taking risks, corporate decision-makers consciously attempt to maximize the present value of the corporation's expected income and, thereby, benefit shareholders.24 Anyone with an interest in the future profitability of a corporation would likely want that corporation to take risks and insist that governance mechanisms allow its leaders to do so.25 Any fair summary of American corporate legal history would show that this model has been followed for at least the last one hundred years. While individual corporations maximize the wealth of their shareholders by embarking on risky ventures, many of the arguments in favor of the business judgment rule also rely on a second notion-the ability of shareholders to diversify their holdings across many corporations and therefore diversify their risk as well. 26 In Gagliardi, for example, Chancellor Allen justifies the broad protections of the business judgment rule on the ground that shareholders should not rationally want directors to be risk averse: "[s]hareholders' investment interests, across the full range of their diversifiable equity investments, will be maximized if corporate directors and managers honestly assess risk and reward and accept for the corporation the highest risk adjusted returns available that are above the firm's cost of capital. 27 Similarly, Stephen Bainbridge invokes portfolio theory to argue that, since shareholders can diversify their portfolios, they should be indifferent to decisions by directors that affect the risks faced by an individual corporation as long as those decisions are designed to increase the rate of return of that specific 24. Allen et al. explain how a very risky decision might be in the best interest of the corporation: "Because the expected value of a risky business decision may be greater than that of a less risky decision, directors may be acting in the best interest of the shareholders when they choose the riskier alternative." Allen et al.su pra note 22, at 455. 25. As Bainbridge explains, we can view the business judgment rule as an "off-the-rack rule" that essentially imposes by default a rule that the shareholders would willingly agree to by contract - a promise on their part "to refrain from challenging the reasonableness of managerial business decisions." Stephen Bainbridge, The Business Judgment Rule as Abstention Doctrine, 57 VAND. L. REV. 83, 114- 116 (2004). 26. This argument seems to disregard the contractarian view of the corporation, a theory which many of the business judgment rule's strongest proponents embrace. To a contractarian, a director owes fiduciary duties to the shareholders in a way that is similar to the duties a party assumes under an ordinary contract. David Rosenberg, Making Sense of Good Faith in Delaware Corporate Fiduciary Law, 29 DEL. J.C ORP. LAW 491 (2004). Surely in defining those duties, the parties do not assume that the shareholders must hold shares in other corporations. The duties owed by a director, whatever they might be, ought to be defined within the confines of the conglomeration of relationships within that specific corporation. To define the duties owed by a director to a shareholder with reference to the fact that the shareholder likely owns stock in other corporations seems akin to mitigating the liability of a negligent babysitter on the grounds that, well, the parent probably has other children who will not have been harmed by that babysitter's lack of care. 27. Gagliardi v. Trifood Int'l, 683 A.2d 1049, 1052 (Del. Ch. 1996). This assumption may well have played a crucial role in the meltdown of 2008. In advocating for greater regulation in the wake of the events of the Fall of 2008, Martin Wolf of the Financial Times writes, "In particular, far more attention must be paid to behaviour that may appear rational for each institution, but cannot be rational if all institutions are engaged in it at the same time." Martin Wolf, The end of lightly regulatedf inance has comef ar closer, Financial Times, Sept. 16, 2008. Supplying the Adverb corporation.28 Indeed, the holder of shares in a publicly traded corporation likely owns shares in other publicly traded corporations as well.29 Plainly, to maximize the overall value of a diversified portfolio of holdings, the broad protections of the business judgment rule serve the shareholder well by encouraging directors to take risks without fear of liability even if those specific risks do not ultimately add value to the corporation that they oversee. A third notion supporting the broad application of the business judgment rule is the notorious complication that inevitably accompanies judicial review of business decisions. The problem with allowing courts to review the decisions of corporate directors is not that sometimes the directors get it wrong; no one seriously suggests that investors should be able to recover from directors any time a decision ends up hurting the corporation.30 This understanding is implicit in any discussion of the workings of a market economy that recognizes the corporate form.31 The real problem with reviewing bad decisions by corporate directors, as many commentators have pointed out, is that courts will sometimes error in their determination of how and why the directors made a mistake. Both common sense and empirical studies33 tell us that any attempt to judge or analyze a decision after the results of the decision are already known may be tainted by "hindsight bias."34 Whatever the standard a court might use in evaluating a claim regarding a decision made in the past, it will be difficult for the court to ignore the known consequences of the decision. As Bainbridge puts it: "[d]ecision makers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring."35 Hence, many fear that absent the strong protections of the 28. Bainbridge, supra note 25, at 112-14. 29. Still it is unclear why this should at all affect the culpability of the directors. Although the misconduct in the Enron debacle was far worse than the kind of borderline bad faith contemplated here, the fact that the retirement plans of many Enron employees were made up almost entirely of stock in Enron itself made the impact far more devastating. Michael W. Lynch, Enron's 401(k) Calamity, Reason Magazine, Dec. 27, 2001. The failure of the Enron employees to diversify was a bad investment decision for them. But even if they had diversified, that should not have mitigated the culpability of the Enron leadership. 30. Indeed, it might be said that the business judgment rule (which to a degree prohibits recovery even when the actor made a bad decision) is the polar opposite of strict liability (which imposes liability even where the plaintiff cannot prove that the actor made a bad decision). 31. Judge Winter described this assumption nicely in his oft-cited opinion in the well known case of Joy v. North: "First, shareholders to a very real degree voluntarily undertake the risk of bad business judgment. Investors need not buy stock, for investment markets offer an array of opportunities less vulnerable to mistakes in judgment by corporate officers . . . . [tihe business judgment rule merely recognizes a certain voluntariness in undertaking the risk of bad business decisions." 692 F.2d 880, 885- 886 (2d Cir. 1982). 32. For a non-legal example of hindsight bias, listen to a random five-minute segment of any sports-related, radio call-in show anywhere in the world on a Monday morning. 33. Allen et al., supra note 22, at 454-55. See also Bainbridge, supra note 25, at 114. 34. See Andrew S. Gold, A Decision Theory Approach to the Business Judgment Rule: Reflections on Disney, Good Faith, and Judicial Uncertainty, 66 MD L REV 398,443 (2007). 35. Bainbridge, supra note 25, at 114. Berkeley Business Law Journal Vol. 6.2, 2009 business judgment rule, courts would be tempted to hold directors liable for good-faith decisions that did not end up benefiting the corporation.36 Finally, a fourth notion that informs the rationale of the business judgment rule is what Chancellor Allen in Gagliardi called "this stupefying disjunction between risk and reward for corporate directors."37 As he explains, corporate directors generally do not own a large percentage of the stock in the corporations that they oversee.38 When directors take a risk that succeeds in producing wealth for the corporation, they benefit by perhaps a decent gain in their equity share of the corporation and certainly a gain for their reputation as good leaders and decision-makers. Similarly, if they take a risk that produces losses for the corporation, the directors will take a small equity hit and a concomitant dent in their reputations as good leaders. However, as Allen emphasizes, if courts were to hold directors personally liable for the damages arising from their unsuccessful risky decisions, the law would minimize directors' incentives to take the kind of risks that shareholders would want them to take.39 The current business judgment rule, then, simply puts the potential for personal damages in line with the potential personal payoff that might result from the authorization of a risky venture by corporate directors.40 Since the potential financial payoff for most directors is very low (because they possess little equity in the corporation), their potential liability should be very low as well. 36. As other commentators have pointed out, however, this does not stop our legal system from allowing judges and juries to determine the reasonableness of an actor's actions in a variety of areas of professional endeavor or everyday life after something goes wrong. See, e.g., FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 94 (Harvard Univ. Press 1991) (pointing out that judges routinely "decide whether engineers have designed the compressors on jet engines properly" and "whether the farmer delivered pomegranates conforming to the industry's specifications"); Gevurtz, supra note 17, at 305. But see Telman, supra note 17 at 841-42. 37. Gagliardi v. Trifood Int'l, 683 A.2d 1049, 1052 (Del. Ch. 1996). See also, Allen et al., supra note 22, at 456 ("But directors will tend to deviate from this rational acceptance of corporate risk if, in authorizing the corporation to undertake a risky investment, the directors must assume some degree of personal risk relating to ex post facto claims of derivative liability for any resulting corporate loss"). 38. Gagliardi, 683 A.2d at 1052. Stephen Bainbridge, however, notes that corporations sometimes require directors to buy stock in corporations in which they serve. Bainbridge, supra note 23, at 117. This would work to align the interests of directors and shareholders and lessen, to a degree, the disproportion between the reward for successful risks and the penalty for those that fail. 39. See Allen et al., supra note 22, at 455 ("A standard of review that imposes liability on a board of directors for making an 'unreasonable'(as opposed to an 'irrational') decision could result in discouraging riskier yet socially desirable economic decisions, because an ordinary negligence standard of care will tend to make directors unduly risk averse"). 40. In Gagliardi, Allen writes, "Given this disjunction, only a very small probability of director liability based on 'negligence,' 'inattention,' 'waste,' etc., could induce a board to avoid authorizing risky investment projects to any extent!" Gagliardi, 683 A.2d at 1052. It appears that Allen means that even a small probability of liabilwiotuyld cause a director to avoid risks because the rewards for success are disproportionately small compared to the damages resulting from failure. Effectively, the business judgment rule allows directors to take risks without fear of that liability.